WHILE Chinese investors fret over the bursting of the stock bubble, global investors are more worried about the yuan currency that once seemed destined to rise inexorably.

    A decade after China released the yuan from its peg to the U.S. dollar, more international money managers no longer regard the currency as a one-way appreciation bet that will augment their returns on stocks and bonds in dollar terms.

    “For years, one of the arguments was that the yuan was undervalued and it would go up,” said Zsolt Papp, client portfolio manager at JPMorgan Asset Management. This argument has been weakening for some time, he said. “That’s added more volatility and uncertainty to your investment decision.”

    Foreigners have been fairly sanguine about the US$2 trillion wiped off the value of Chinese shares listed in Shanghai and Shenzhen as they collectively hold less than 2 percent of the market. They likewise hold only an estimated 2 percent of the US$6 trillion local bond market.

    But they have major holdings in H shares, the US$3.7 trillion market in Hong Kong-listed stock of mainland companies, and “dim-sum” bonds, the US$70 billion-plus market for yuan-denominated debt issued and traded offshore.

    For years, many of these investments were built on the assumption that the yuan, as the lynchpin of China’s strategy to rebalance its economy away from exports and toward domestic consumption, would move higher.

    Those bets have been rewarded: since 2005, the yuan has risen about 30 percent in nominal terms against the U.S. dollar. But this course is likely to be less smooth from now on.

    Last week, a statement from China’s State Council, or Cabinet, saying China would widen “two-way fluctuation” in the exchange rate to support trade provoked short-lived volatility. This sent yuan traded offshore to two-week lows against the dollar.

    The People’s Bank of China allows yuan traded domestically to rise or fall only 2 percent from a midpoint rate it sets daily. Offshore yuan trade is not constrained by this band, although in practice the two exchange rates usually move in lockstep.

    Non-deliverable forwards, derivatives used to lock in future exchange rates, indicate the onshore yuan 1 percent weaker in a year.

    China could probably benefit from a weaker currency. Its economy is growing at the slowest pace in 25 years and rival exporters, Japan and South Korea, may enjoy an upper hand thanks to the weak yen and won.

    By contrast, the yuan is near record highs in real effective (REER) terms — versus the currencies of trading partners and adjusted for inflation — having risen steadily since its fixed peg was loosened in July 2005.

    Barclays calculates the yuan is 18 percent overvalued and sees it at 6.35 per dollar by the end of this year compared with 6.2 now, assuming the trading band is widened to plus/minus 4 percent.

    Expectations that the currency will depreciate could increase demand for hedging yuan-denominated assets or cash flows, while reducing appetite for dim-sum bonds and H shares, Barclays predicted.

    China may be far from sanctioning big devaluations, however. It is keen for the yuan to be included in the International Monetary Fund’s special drawing rights (SDR) basket of reserve currencies following a review in November and is therefore unlikely to allow sharp exchange rate swings in the meantime.

    Another sticking point is the US$1.7 trillion in total Chinese foreign debt, of which 70 percent is classed as short-term. A weaker yuan would make it harder for Chinese borrowers to service this debt.(SD-Agencies)